Using Price Action for Day Trading

In current days with the US economy in trouble, inflation and sure recession, and a bearish structure and high volatility in markets, it's risky for a cautious trader to create a long-term portfolio. Today it's advisable to do swing or day trading, that's quick trades holding the stock for hours to days (intraday) for immediate profit-taking before the market turns against us. But don't exaggerate with many day trades (easy today with 0% commissions), a common practice of novice traders: overtrading can be devastating for any account or even worse, a margin account. One must know how to step aside at the right time: it's also part of the successful trader's strategy. The idea is to preserve cash and do a few day trades, closing them usually before the session ends to avoid morning gaps. 

For day trading is mandatory to keep an eye on the news, economic events, earnings, insiders, and popular market movers, as day traders gain with their explosive moves. In fact, day trading is mainly designed for professional traders (or gamblers as well!) who can access the trading desk, a great advantage over the retailers. So, manage your risk. And execute your edge with discipline. That's all the game. You can be lucrative if do it properly.

A few words about Scalping strategy

Unlike swing or day trading, where times allow corrections in the strategy and risk management during the price movement, in scalping (not exactly my favorite strategy) is quite complicated, hence it is considered a high-risk strategy. And unlike day trading, scalping does not depend on news, the economy, or fundamentals of the stock. It`s enough to define the intraday move (trend or range) of a stock, which needs very high liquidity, or a tight spread bid-ask.

Since it's about making multiple daily operations with small quick profits, the idea here is to create a system that works, with few (and fixed) rules and applies it disciplined many times a day, like a robot without changing it, strictly respecting the entry and mainly the exit. It is understood that this system has been developed and fine-tuned after many hours of practice, constantly monitoring the market. And the price action is the best (and usually only) tool here because it allows quick decisions without waiting for the slowness of all the indicators.

Price Action Basics for Day Trading

Price Action Analysis is, once again, also my main weapon for day trading. Basically, you have to follow the same four principles indicated in the previous post refer to Price Action basics, obvious with slight changes, due to this strategy:

1. Being a "fast" strategy, the most optimal operative timeframe for day trading is the shortest possible, as a 5-min chart. Take note that charts of 1min or even fewer (ticks) give many signals at full speed that, for me, don't allow a good analysis. They are fine for scalping where you need only a proven entry and exit method.

2. As usual, use the support/resistance levels, trendlines, or price patterns, that were drawn in the higher timeframe.

3. Use Price Action techniques, reading the candlesticks and their patterns at a glance, mainly when the price approaches an S/R level. Do always in conjunction with volume.

4. Maintain clean your charts, using specific technical indicators. As usual, for me, it's enough one trend indicator like the moving averages (for day trading I use exponential moving averages as the EMA50 because I require one faster than the simple SMA50) and one oscillator (as always the Relative Strength Index RSI).

Additional technical indicators recommended

As day trading is a high-risk strategy, I consider two more "different" indicators that give great signals for use only as confirmation, never as an entry strategy. All these indicators are treated previously in this blog:

- The Volume-Weighted Average Price VWAP: basically a moving average with the same weighted average we learn in school, this time with volume traded. Below I explain its main features and how I use it.

- The Volume Profile, considers volume not a specific time, but a specific price, creating important support and resistance levels. Review its main features in the previous post.

VWAP, a great indicator for Day Trading

The volume-weighted average price is a powerful trend indicator for day trading, and it's crucial due to its heavy use by investment funds and smart money. It looks like a moving average and is the same weighted average we learn in school, in this case, combining the two main factors involved in trading: price and volume

As stocks need liquidity to pump up and drive their price action, VWAP, as an average that lags, allows reading momentum. Therefore, when VWAP slopes up, it indicates prices are trending up, and when it slopes down, prices may be trending down. If it's relatively flat means momentum is low, so the price is in consolidation.

In a practical way, I use the VWAP in two different ways, in the operative (lower) timeframe, depending on the type of trade involved: Trend Trading (pullbacks) or Breakout Trading (breakouts).

- For pullbacks, I only use VWAP in a clear and strong uptrend. During that trend, the stock price usually makes a pullback to the downside, returning to the VWAP. So, buy that rejection at the VWAP price. Be careful if the price crosses the VWAP. That invalidates this simple strategy.

- For breakouts, look first when the price is below the VWAP and, due to its price action, cross it with a big momentum candle. If this candle also breaks any of your resistance lines (or a trendline), that reinforces the strategy. Then look to buy above the high of the big candle that closed above the VWAP: that's the entry point. This strategy also works for support levels and always needs a high volume confirmation.

Consider that institutions work its many investor's large accounts always buying below the VWAP and selling above it. This way their actions push the price back toward the average, instead of away from it. That's great information for retail investors and traders!

In the 1-min chart above the Russell2000 future /RTY was in a daily strong uptrend on April 2020. Check that for three times its price pullbacks to the (orange) VWAP, in the grey circles, rebounding then exactly at that level, that not necessarily was a tradeable structure level. That's the power of the VWAP in strong trends: can work alone with price action.

Check also the EMA50 (in light blue): its break at 06:00 signals the trend change and the beginning of a healthy trend. If you buy those rejections, trailing your stop-loss, you can get nice profits on your day trades.

A note for day trading: consider that the VWAP calculation ends when the session stops, therefore a new VWAP starts ticking in the next session. That doesn't mean you can't use VWAP in any timeframe, to identify trends or price reversals.

Finally, in a strong uptrend consider the two following tips during your price action analysis:

- Consider that price is never "too high" or "too low". Just follow the trend and trust in your Price Action Analysis with your tools (candlesticks and recognizable price patterns, supports and resistance lines, trendlines, etc) to predict the next movement.

- When the price breakouts a level, there are no pullbacks if the price moves with heavy momentum, verified by big confirmation candles. And use continuation price patterns like flags, pennants, or triangles, as great levels to capture momentum during the trend.

Apply your usual trading plan with high-control emotions

My recommendation for doing intraday trades is to necessarily use Price Action Analysis for entry/exit signals, on adequate timeframesI am comfortable with two timeframes: a higher of 1 or 4 hours (to define the trend and draw main levels, trendlines, and patterns) and a lower of  5 or 15 min (to find key levels, get details, and operate using techniques previously explain for trend or reversal trading). Remember we are day trading, no need for greater timeframes.

To identify the trend, the faster exponential moving average EMA50 is a good alternative, plotted in the higher or both timeframe. It works simply: if the stock price is above it for an extended period of time, it's good, it's in a healthy uptrend. If it's below, the stock is doing bad, showing weakness. And it also can act as a dynamic form of support/resistance: price crossing the EMA50 means a possible trend change. I also usually add, only in the higher timeframe, the EMA100 to see the signals that the crossovers between both give, always useful.

Obviously, all items explain in the previous Price Action post apply for day trading. Briefly:

- Use the higher timeframe for drawing your support/resistance main levels, and price patterns, known by all traders: up/down trendlines, channels, triangles, wedges, head & shoulders, cup & handle, and double top/bottom. And use the lower timeframe to find key levels, get more details, and therefore precise entry and exit levels.

- In day trading, more than in any other strategy, you need to "read" each candlestick at a glance and what it means (indecision, rejection, reversal, momentum). For example, the bullish Hammer, which represents the bottom of a trend, and the opposite bearish Shooting Star, the end of an uptrend. Or the bullish and bearish Engulfing, my favorite reversal candlestick pattern. All of them, need further candlestick and volume confirmation.

- So, what I do is use my usual trading plan with these day trading setups, initially focusing on a few stocks with an entry-and-exit method well defined, and mainly try to understand what price action is telling you. Finally, day trading is about applying the same price action concepts in a smaller timeframe, which demands more precision in reading the candlesticks, and some additional confirmation from a technical indicator, in addition to the most important: a greater emotional control.

In this practical case, $GDX, a popular ETF that follows gold miners, has been trading this week in the range of <$32.20, 32.83> plotted on the 1-hour chart (not shown), which created the two short-term S/R levels shown. On Wednesday, the price began the session going down, reaching weekly support, where a multiple rejection began (in yellow, similar to a triple-bottom pattern), which only gave a buy signal when it broke the downtrend line with a momentum candlestick (in the pink circle).

Level that also coincides with an RSI divergence, with the break of the (orange) VWAP and with a POC of its Volume Profile: the reversal trade was "sure" there. The exit trade occurs at the end of the session when the price again presents rejections at the height of the second POC, a key level.

The next day, it's another story: there is a trend trade. After an initial explosion, the price reaches its weekly resistance with a pin-bar that is confirmed with a big red momentum candle (grey circle). It can be a good point to enter short, although a careful trader would expect the deep break of the VWAP with that big candle (in the pink circle). From there begins the downtrend, with two pauses at the (purple) flags where the price takes a breather to continue its downward path that reaches weekly support, an obligatory exit point for a day trader.

Check that the two pullbacks from the flags form a clear bearish RSI hidden divergence, a trend-continuation signal. Price continues falling, even more strongly after the signal.

Also check that the MACD-RSI duo worked well, giving two additional signals to the main price action, at the beginning and at the end of the swing: it is the application of Alexander Elder's tip "buy when the MACD histogram rises and the RSI is low, and sell when the MACD decreases and the RSI is high".

As you can see, again, the rules are simple and easy to understand but require many hours of practice, a lot of time with the "trial and error" method, first on papermoney mode and then in real-time. And finally, perhaps more than in any other strategy, for the stressful day trading you must know how to manage your emotions, as suffering losses is usually typical for a beginner day trader. Remember always the popular adage on Wall Street that says that "stock trading is 10% strategy, 30% risk management, and 60% psychology". 

Good Trading,

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